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6-7 Yield curve and the term structure of interest rates Term structure – relationship between interest rates (or yields) and maturities. The yield curve is a graph of the term structure. The November 2005 Treasury yield curve is shown at the right.

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6-12 Pure Expectations Hypothesis The PEH contends that the shape of the yield curve depends on investor’s expectations about future interest rates. If interest rates are expected to increase, L-T rates will be higher than S-T rates, and vice-versa. Thus, the yield curve can slope up, down, or even bow.

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6-13 Assumptions of the PEH Assumes that the maturity risk premium for Treasury securities is zero. Long-term rates are an average of current and future short-term rates. If PEH is correct, you can use the yield curve to “back out” expected future interest rates.

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6-14 An example: Observed Treasury rates and the PEH MaturityYield 1 year6.0% 2 years6.2% 3 years6.4% 4 years6.5% 5 years6.5% If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now?

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6-15 One-year forward rate (1.062) 2 = (1.060) (1+x) 1.12784/1.060= (1+x) 6.4004%= x PEH says that one-year securities will yield 6.4004%, one year from now. Notice, if an arithmetic average is used, the answer is still very close. Solve: 6.2% = (6.0% + x)/2, and the result will be 6.4%. 0 1 2 6.0%x% 6.2%

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6-17 Conclusions about PEH Some would argue that the MRP ≠ 0, and hence the PEH is incorrect. Most evidence supports the general view that lenders prefer S-T securities, and view L-T securities as riskier. Thus, investors demand a premium to persuade them to hold L-T securities (i.e., MRP > 0).

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6-19 Risks associated with investing overseas Exchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment’s value will depend on what happens to exchange rates. Country risk – Arises from investing or doing business in a particular country and depends on the country’s economic, political, and social environment.